A return to RoEs

With a year-end rally looking unlikely, it’s time to polish old arguments for explaining the lack of foreign investor interest in Indian stocks. Rate hikes, political paralysis, the series of scams and the European tragedy are well known.

Onwards to another favourite then - the dip in the return of equity (RoE) premium, as Morgan Stanley pointed out in a recent note which looks exceedingly the same as one published on 31 March except for some references to the F1 race.

As the chart shows, India no longer has the edge in RoE. Of course, you have already read about the arguments of heavy capital expenditure, falling asset turnover and equity dilution during the boom years leading to a fall in RoE. (See Mint stories from 19 June and 1 April)

But interestingly, RoE seems to be inching up again, at least for the MSCI India sample. At first blush, that might not be too surprising. After all Indian companies are slowing down on capital expenditure. Although capacity utilization among Indian companies fell sequentially to 72.3% in the June quarter, it was the highest for three years in January-March. The fall in June too might be a seasonal decline. In the past couple of quarters, volume growth for many Indian companies has been decent and that should help push up capacity utilization and therefore, the asset turnover.

That said, it will take some time for Indian companies to report higher levels of RoE a la’ the wonder years of the mid-2000s. Large acquisitions in past few years (foreign companies have lower RoEs) and monetary tightening may continue to have a lag effect on RoEs, says Harendra Kumar, who heads research at Elara Capital.

So, it might quite some time before valuations of Indian stocks – currently trading at 13 times one-year forward earnings – exceed the long-term average price-earnings multiple of 15 times.